Financial Pacific - Here we go again (third party)


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Financial Pacific - Here we go again (third party)

  1. 1. Research note: August 2011Here We Go Again
  2. 2. Here We Go AgainHere We Go Again1 Recent equity market action has been uncomfortable but, having experienced the pain, we recommend calm – avoid knee jerk reactions. In practice, it is hard to identify market bottoms1 At current valuations, long term returns from US equities look reasonable and because of the certainly much more attractive than those available from government bonds. uncertainty implicit in1 Yields on government bonds may fall further from here if the chaos persists but them. What we do know the medium term opportunity cost of being underweight government bonds is is they tend to be low. associated with a period1 Market bottoms are, by their nature, highly uncertain beasts associated with of heightened volatility elevated volatility. The bottoming process usually takes some time and it is as the balance shifts from possible that recent lows are retested before positive trends reassert themselves. sellers to buyers.1 Structural headwinds to the market stem from two primary (related) sources: European sovereign debt problems and ongoing deleveraging. We do not expect either of these headwinds to be resolved quickly and they will therefore act as a constraint on market growth.1 The economic data has deteriorated recently although there are also some indications that the situation is not as bad as markets have priced in. We do not expect a double dip although the probability of one has increased.1 We will continue to monitor markets and the data closely. Until we witness further meaningful deterioration, we expect to maintain current equity weightings in our portfolios. It is important to maintain a disciplined investment approach through this difficult period.Market action of the past few weeks has been exceptionally earnings are elevated (depressed) because of a cyclicalvolatile, albeit less so than at the depths of the financial crisis in upswing (downswing) this approach adjusts them down (up)the fourth quarter of 2008 when Lehman Brothers filed for and calculates a market valuation accordingly. We have foundbankruptcy. The banks are once again at the centre of this storm, this a useful tool for anticipating equity market returns overwith the focus having shifted from US to European financial the next ten years. Chart 1 shows this measure together withinstitutions. Human beings have evolved over thousands of implicit ten year ahead forecasts.years to react to such extreme situations via the “fight-or-flight”response. This means that decisions over whether to stay andfight against adversity or to cut one’s losses and run are highly Chart 1instinctual. In current circumstances the sense of helplessness Cyclically Adjusted Valuations and Expected Returnsfelt by many investors against the might of the market is likely tobe encouraging flight and we are sympathetic to this discomfort.Nonetheless it is important to maintain a sense of perspective,something we attempt to achieve in the observations below.Long Term Equity Return ExpectationsWith earnings expected to reach around $97 for 2011 and theS&P500 trading at around 1140 (at the time of writing), thisputs the prospective multiple at just under 12x. This is notoutrageously cheap but it is definitely on the right side of theexpensive:cheap divide. A more conservative approach (thatdoes not rely on forecast earnings for the remainder of 2011)uses national accounting data and then adjusts for the cycle; if Source: Federal Reserve, Bureau of Economic Analysis, Bloomberg, EFG calculations01
  3. 3. Here We Go AgainThe red line in the chart is actual ten year ahead returns. It less than 1.0%, long run prospective returns from governmentstops in 2001 because that was ten years ago and it is not bonds look poor. It is important to note that this is not apossible to calculate returns over periods that have not yet forecast that yields will rise sharply from here – in the short runhappened. The grey line is the cyclically adjusted PE ratio and they may well fall further if market volatility continues. Wethe green dotted line is the forecast implied by the cyclically note though that the opportunity cost of not being invested inadjusted PE ratio. Thus, in the second quarter of 2001 the government bonds is low even if yields do continue to fall.model was anticipating average annualised returns of -3.2%over the following ten years, taking into account inflation and Market Bottomsdividends, and actual returns were -2.9%. The market bottoming process is complicated. At some pointThe current cyclically adjusted PE ratio is anticipating real asset prices fall so far that the perceived risk is offset by theaverage annualised real returns of +3.4% over the next ten potential returns, at least to some investors. However, no oneyears. This is not as high as during the lows of the financial knows exactly when this happens. By its nature this process iscrisis in late 2008 and early 2009 when annualised returns of highly uncertain; if it were obvious that assets were cheaparound 7.0% were expected but it does represent a perfectly then everyone would be buying and prices would never fall soattractive inflation adjusted return. Of course what this model low in the first place. Price volatility would be greatlydoes not tell you is what volatility one might expect to be diminished and long run returns would be reduced. Inassociated with this return – markets do not travel in straight practice, it is hard to identify market bottoms because of thelines. However, the model does indicate that, if one looks uncertainty implicit in them. What we do know is they tend tothough short term gyrations, expected returns from equity be associated with a period of heightened volatility as themarkets look reasonable. There may well be better times to buy balance shifts from sellers to buyers.but the model suggests that owning equities at these levels To illustrate this point Chart 3 shows how market bottoms inwill result in satisfactory returns.Government Bonds Chart 3 Market Bottoms and VolatilityBalanced portfolios usually have some exposure to equitiesoffset by exposure to government bonds. The theory is thatduring times of stress the two are negatively correlated suchthat government bonds rally when equity markets fall. That hascertainly been the case recently. A paradox of this analysis isthat the lower government bond yields fall, the lower longterm returns to be expected from them.Chart 2Bond Yields and Prospective Returns Source: Bloomberg, EFG calculations 2002 and 2008 were both associated with relatively prolonged periods of elevated market volatility. We note further that the market did not reverse suddenly from a low but in both instances spent a period of time trading around the lows before accelerating from there. Unfortunately it is difficult to tell if current volatility is associated with a market low or if it is the precursor to further declines. If experience is a guide, it would not be unusual for the recent lows to be retested beforeSource: Bloomberg, EFG calculations an uptrend reasserts itself. Given the headwinds markets currently face it is not impossible that the market takes anotherWe showed in a previous report1 how the five year Treasury leg down although this is not currently our core view. Weyield provided a good forecast of the returns one could expect remain alert to this possibility and will be monitoring marketsfrom government bonds over the subsequent five year period and associated data closely.– see Chart 2. With the five year US Treasury currently yielding 02
  4. 4. Here We Go AgainHeadwinds What To DoIn a recent report2 we highlighted various risks investors must Maintaining a disciplined investment approach is important incurrently evaluate. We expect European sovereign debt such situations as is keeping a longer term perspective onproblems to continue to punctuate the investment landscape asset prices and implied potential returns. As the famousfor sometime with the endgame probably requiring much Warren Buffett quote goes “Be fearful when others are greedygreater ECB involvement. Until then a large shadow will be cast and greedy when others are fearful.” This may meanin particular over European financial institutions but also over stomaching some short term volatility but one only has to lookfinancial institutions in other countries. This will limit the pace at Buffett’s track record to realise what a sensible approach it is.of any equity market gains. Nevertheless, behavioural biases are deeply imbedded in the human psyche and, however rational such quotes may seemThe ongoing deleveraging process also represents a risk and when markets are calm, they are much harder to adhere towill be a constraint on economic growth. History suggests that during the turmoil associated with sharp falls. Our central view,economies take on average something like six or seven years therefore, may be summarised as one in which equity marketsto recover from financial crises as leverage is unwound to more are going through a volatile bottoming process with some risksustainable levels. Given that we are around three to three- to the downside. We will continue to closely monitor the dataand-a-half years from the start of the most recent financial for signs of deterioration but in the meantime have maintainedcrisis, this would suggest that we have another three to a constructive position on equities in our portfolios.three-and-a-half years to go before the situation is properlyresolved. Moreover, the large and global nature of the recentfinancial crisis may mean that it takes longer on this occasion. FootnotesThis too will act as a headwind. 1 See EFGAM research note “Big Bond Trouble and a Little China Vendor Financing”, September, 2010.Chart 4 2 See EFGAM research note “On Singultus and Second Derivatives”, July 2011.Probability of Recession Implied by the Yield Curve SlopeSource: Federal Reserve Bank of New YorkShort term uncertainty over the economic environment hasalso escalated recently and with it some question marks haveappeared over earnings estimates for the remainder of 2011and 2012. To be sure there certainly has been some evidence ofeconomic weakness recently such as a rollover in purchasingmanagers’ indices. There have also been some reasons to feelmore optimistic such as a pick up in corporate and consumerloan growth as well as continued growth in leading indicators.Our view remains that we do not expect a double dip but wecannot rule one out and we will continue to monitor the datacarefully for signs that the situation is deteriorating.
  5. 5. Here We Go AgainAbout the author Daniel Murray Daniel Murray is Global Head of Research at EFG Asset Management. He was previously employed as a Director of Strategy at Russell Investments, before which he worked as a portfolio manager at Merrill Lynch Investment Managers. He began his career at Smithers & Co. Ltd. He has broad investment experience, having worked as an economist, strategist, asset allocator and portfolio manager with exposure to a broad range of markets, instruments and investment styles. He has been a CFA charter holder since 2003. Daniel has a BSc Hons Degree in Economics, an MSc in Econometrics and Mathematical Economics and a PhD in Economics. In 2009 he was awarded the CFA UK Wincott Prize.DisclaimerIssued by EFG Asset Management, a division of EFG Private Bank Limited, which is authorised and regulated by the Financial Services Authority, 25 The NorthColonnade, Canary Wharf, London E14 5HS. EFG Private Bank Limited is a member of the London Stock Exchange. A member of EFG International. Registeredin England and Wales. Registered no. 2321802. Registered office at Leconfield House, Curzon Street, London W1J 5JB. This document has been approved solelyfor distribution in the United Kingdom; its publication or availability in any other jurisdiction or country may be contrary to local law or regulation.Not all products, services or investments described on this document are available in all jurisdictions and some are available on a limited basis only, due tolocal regulatory and legal requirements. Some products and services may be available only through particular EFG Private Bank Limited divisions or associatedcompanies. Certain aspects of the service may be performed through, or with the support of, diff erent members of the EFG International Group, of which EFGPrivate Bank Limited is a member. This document has been approved solely for distribution in the United Kingdom; its publication or availability in any otherjurisdiction or country may be contrary to local law or regulation. Any use of this document is entirely at your own risk. For guidance on rules governing youruse, please contact a legal adviser.Any investment information which may be provided in this document is provided for illustration only. Although information in this document has beenobtained from sources believed to be reliable and correct, we do not represent or warrant its accuracy, and such information may be incomplete or condensedand cannot be guaranteed. Information in this document is not intended as an off er or solicitation to buy or sell securities or any other investment or bankingproduct. It does not constitute a personal recommendation nor is it intended to provide the sole basis for any evaluation of investments which may bediscussed in it.Illustrations of the likely risk and reward of example portfolios and investments in this document is not specifi c advice and you should not rely on it. Anyillustrations are accurate at the time of writing, and may be subject to change. The value of the investments which may be stated in this document, and theincome from them, may fall as well as rise and you may not recover the amount of your original investment. Past performance of investments is no guide tofuture performance. Any income projections and yields are estimated and are included for indication only.Data which may be found on this document is based on quantitative research and analysis of historic data. It should not be taken as a forecast or estimate oflikely future returns. The actual performance of any investment might be more or less than is stated in any illustration. Where an investment involves exposureto a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.The analysis in this document has been procured, and may have been acted upon, by EFG Private Bank Limited and connected companies for their ownpurposes, and the results are being made available to you on this understanding. To the extent permitted by law and without being inconsistent with anyapplicable regulation, neither EFG Private Bank Limited nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such analysis. Reproduction of this document, either in wholeor in part, is expressly prohibited without prior written permission from EFG Private Bank.
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